Don't Let the Latest GDP Report Fool You

This past Friday, July 27, the Department of Commerce reported that the U.S. economy rebounded sharply in the second quarter of this year, growing at an annualized rate of 3.4 percent. Not surprisingly, the Wall Street cheerleaders gleefully talked up the resurgence in America's gross domestic product and the underlying strength in the economy.

Although the economy did in fact expand during the second quarter, the numbers were no where near as strong as the government and most Wall Street money managers would have you believe.

For example, real GDP grew at a year-over-year rate of only 1.8 percent during the second quarter, as compared to an annualized rate of 3.4 percent.

For those of you who don't understand the difference, the year-over-year rate involves what actually occurred, while the annualized rate reflects what could occur if the economy continues to expand over the next four quarters at the same rate it grew during the period from April through June of this year.

This is a very important distinction, because no sane person would expect the economy to grow at the same rate in the future as it did during a single three-month period. But, this is exactly what the government assumes when it reports the economy's "annualized" growth rate.

As an analogy, think of it in this way: If you were fortunate enough to realize a 10 percent return on an investment during a particular three-month period, would you assume that you would earn a 40 percent return over the next four quarters (10 percent times four three-month periods)? The answer, of course, is no.

A closer review of GDP reveals that the U.S. economy has slowed considerably over the past several quarters and that growth will likely continue to slow later this year. For example, the economy grew at a year-over-year rate of 3.2 percent during the second quarter of last year, which is clearly a much faster pace than this year's second-quarter pace of only 1.8 percent.

The details behind the numbers are even more troublesome. For example, in any given year, consumer spending tends to account for approximately 70 percent of GDP. Yet, consumer spending has slowed considerably over the past three quarters. More importantly, the modest increase in consumer spending during the second quarter was due primarily to spending on services, rather than spending on household durable goods (such as electric appliances). Spending on non-durable goods actually declined in the most-recent three-month period.

Meanwhile, the biggest contributor to the business investment component of GDP was spending on structures (i.e., office and industrial complexes). Although such investments are important for an economy's long-term growth, large investments of this sort are generally one-time events. In contrast, business investments in inventories — the products that businesses manufacture or purchase from other manufacturers to resell to consumers — have slowed dramatically over the past several months.

In regards to the exports component of GDP, net exports did in fact increase during the second quarter. But, you should keep in mind that the growth in exports was largely due to a significant decline in the value of the U.S. dollar, which made U.S. goods much less costly to foreign purchasers of those goods.

Government expenditures and investments also grew considerably during the second quarter. But, the biggest contributor to this final component of GDP came from spending on the military — government spending on the war in Iraq.

I think most investors would agree that this type of spending is probably not sustainable over the coming year, as more and more U.S. citizens are growing tired of the war in Iraq.

So, you can choose to listen to the Wall Street cheerleaders, or you can pay a little more attention to what is actually happening in the U.S. economy. And, I think the details mentioned above clearly demonstrate that the economy is on thin ice.

For more on this subject, I suggest you read the story by my associate John Browne, "Bernanke Buries the Truth on Inflation" to review his thinking.(Go here for the archive of this article.

This past Friday, July 27, the Department of Commerce reported that the U.S. economy rebounded sharply in the second quarter of this year, growing at an annualized rate of 3.4 percent. Not surprisingly, the Wall Street cheerleaders gleefully talked up the resurgence in...